Option ARMS Remain Popular....

Option ARMs Remain Popular Despite Risks and Higher Rates
By Ruth Simon From The Wall Street Journal Online

Despite concerns from regulators, lenders continued to issue large numbers of so–called option ARMs during the first five months of the year, new data show.

An option ARM is an adjustable–rate mortgage that gives borrowers multiple payment choices each month, including a minimum payment, an interest–only payment and a standard mortgage payment. The loans often feature a low introductory rate that is used to set the minimum payment in the first year.

Many borrowers have been attracted to these loans because of their low introductory rates, which have run as little as 1%. But borrowers who elect to make the minimum payment can be hit with a rising loan balance. They can also face "payment shock" down the road, when their monthly payment resets. Roughly 75% of borrowers with option ARMs are currently electing to make the minimum payment, according to UBS AG.

Option ARMs accounted for 12.3% of mortgage originations through May, up from 8.4% in all of 2005, according to a new study by Loan Performance, a unit of First American Corp. The study looked at loans sold to investors that buy mortgage–backed securities. (The data exclude loans sold to Fannie Mae and Freddie Mac, two large mortgage–finance companies whose share of the overall market has been shrinking.)

The loans’ popularity comes as rising interest rates are making them less attractive. Many lenders have boosted their introductory rates to 2% or more. Once the introductory period ends, the true interest rate on the loan can be more than 7%, according to HSH Associates, financial publishers in Pompton Plains , N.J. That is well above the current 6.64% average rate on 30–year fixed–rate mortgages, according to HSH.

"It’s hard to know why anybody would want [an option ARM] in the current rate environment," says Keith Gumbinger, a mortgage analyst with HSH Associates. Yet borrowers seeking to lower their monthly payments have few other choices. Given the narrow difference between short– and long–term interest rates, Mr. Gumbinger says, "there are very few products that...provide payment relief."

There already are signs that some borrowers who took out option ARMs are running into trouble. Foreclosure rates for option ARMs "are rising fast," although they are coming off very low levels, according to a report issued last month by Credit Suisse Group. Option ARMs are going into foreclosure an average of 10 months after the loan is made, earlier than for other types of loans, and that is "a cause of concern," the report said.

Meanwhile, some big lenders may be beginning to push option ARMs less aggressively. Countrywide Financial Corp. says its option–ARM volume was down 42% in July over the same month last year, compared with a 19% decrease in overall loan volume. Downey Financial Corp. said in its second–quarter earnings release that its loan volume had suffered because of the company’s decision to raise the minimum payment on its option ARMs.

Federal bank regulators have proposed guidelines for nontraditional mortgages that would require lenders to provide more disclosure and tighten up their lending requirements. Regulators say they are concerned that borrowers who take out these loans may not fully understand the terms and potential risks of their mortgages. They hope to issue the final guidelines in the next 30 to 60 days, according to the Office of the Comptroller of the Currency.
Despite their downsides, option ARMs have been particularly popular with borrowers who are refinancing. They accounted for roughly 17% of refinance transactions nationwide through May, according to the LoanPerformance analysis, and nearly 37% of refinances in California .

Fewer people have been choosing interest–only mortgages, which allow borrowers to pay interest and no principal in the loan’s early years. Such mortgages accounted for 21.6% of loan originations, according to the LoanPerformance analysis, down from 26.2% last year. Forty–year mortgages have replaced interest–only loans as the "affordability mortgage du jour" for borrowers with blemished credit records, says David Liu, a director in UBS’s Mortgage Strategy Group. Subprime interest–only loans have come under pressure from credit–rating agencies and bank regulators.

SPECIAL THANKS TO RYAN ORR, of First American Title, for copying me on this article....
Enjoy!